What is the primary purpose of a stock split? Should you buy a stock because it might split? It may seem like a gift to some, but there is little evidence that you actually benefit in any meaningful way. That’s why understanding the in’s and out’s of splits are vital before you go out and invest your money in stocks.
Table of Contents
- What is the Primary Purpose of a Stock Split?
- How Do Stocks Split?
What is the Primary Purpose of a Stock Split?
Why Might a Company Split It’s Stock?
For starters, one good reason why a company may split its stock is in a situation where the market price per share is so high that it becomes unwieldy when traded.
In situations like this, when the share price is ridiculously high, small investors may be deterred from buying the shares. But a split will make shares more affordable for more people. It’s important to keep in mind two things. First, a stock split causes a decrease in the price of individual shares.
Second, it does not cause a change in the total market capitalization of the company. Stock dilution does not occur. Our trading service is here to teach you how to take advantage of all market conditions.
An Example of a Stock Split in Action
Humor me for a moment here. Let’s turn back time to Facebook’s infancy and say they issued 100 shares at $50 a share. When you do the math that’s a $5,000 market capitalization (100 x $50).
To calculate the new price of your 200 shares, divide the market capitalization of $5,000 by 200 and you get a price of $25.
Despite the fact that the number of shares increased and the value decreased, the market capitalization is the same as before the split.
Did You Know That Any Split Ratio Is Possible?
More often than not, we tend to see ratios of 2-for-1, 3-for-1, and 3-for-2 splits. However, any ratio is possible.
Companies do use splits however of 4-for-3, 5-for-2, and 5-for-4 for example, though less frequently. Likewise, investors sometimes will get cash payments in lieu of fractional shares.
How Do Stocks Split?
- What is the primary purpose of a stock split? And how do they split? A company decides to trade more shares at a lower price for the existing shares held by shareholders. The new liquidity of the stock mirrors the new price. As a result, shareholders and investors don’t lose their value.
Do Splits Lead to Higher Stock Prices?
Some claim that splits lead to higher stock prices but research does not support this. Now it is true that a split often happens after a run-up in share price but that’s not what causes the run in the first place.
And in fact, momentum investing suggests that the upward trend would continue regardless of the stock split.
In any case, stock splits do increase the liquidity of a stock. Mainly because there are more buyers and sellers for 10 shares at $10 than 1 share at $100.
On the other hand, some companies have the opposite strategy; they refuse to split the stock which keeps the price high, thereby reduce trading volume. One notable example of this is Berkshire Hathaway.
Companies Who Hesitate to Split Their Stock
Perhaps one of the best examples of a company that rarely shows a desire to split its shares of stock is Berkshire Hathaway. At the end of July 2018, Class A shares were trading over $303,000 each.
You read that right, $303,000 each. However, the more accessible Class B shares were trading at around $200.
The Class B shares were created as a compromise between Buffett, who did not want to split shares, and investors who wanted to be able to purchase shares at a reasonable price.
In 2010, the company split the Class B shares 50-1, but has never split Class A shares.
The Psychology Behind Stock Splits
One of the thoughts is that a split is a signal to purchase shares. And if a lot of traders and investors think that a split will increase the share price, they go ahead and purchase the shares and the price does tend to increase.
It’s like the chicken or the egg, which came first? Others interpret a stock splitting as a sign of management confidence in the future prospects of the company.
Have You Heard of a Reverse Split?
If you assumed this was the opposite of the split mentioned above, you’re right. A reverse split is often used to prop up a stock’s price since the price rises on the split.
Mainly companies with low share prices want to increase prices for a number of reasons. First and foremost it could be to raise their profile and gain respect.
Or, it could be to prevent the company from being delisted. If you didn’t already know, many stock exchanges will delist a company if their stock falls below a certain price per share.
Often, a reverse stock split a sign that something is wrong and caution is advised when considering this type of investment.
For example, in a reverse 1-for-5 split, 20 million outstanding shares at 50 cents each would now become 5 million shares outstanding at $2.50 per share. In both cases, the company is still worth $5 million.
I’m sure you’ve heard of Citigroup financial? In May of 2011, they did a 1-for-10 reverse split to reduce their share volatility and discourage speculator trading.
The split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares. When implemented, share price increased from $4.52 to $45.12, and every 10 shares an investor held were replaced with one share.
Like the examples above, the market cap of the company remained the same ($131 billion).
- A stock split is issued by the board of directors of a public company
- An increase in the number of shares in a company
- The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company doesn’t change.
- When a split occurs, the market cap of the company stays the same
- Can be used to attract investors due to the lowered share price
- Splits also add liquidity which makes them attractive to traders
- Many interpret splits as a sign of confidence
Some say a stock split is a good sign; its a sign a stock is doing well and you should consider buying it. But you should caution reading too much into a split by itself.
You should always look at the whole picture before making any investment decision. Ultimately, you only want to buy a stock based on whether it meets your technical or fundamental criteria.
If you’re curious as to how the technical and fundamentals work, we have thousand’s of dollars of free trading courses on our website.